Citi upgrades underperformer Pepper Money to buy

Analysts at Citi expect the industry headwinds will continue in 2024 but pick Pepper on price.

Citi has upgraded Pepper Money to a buy rating following its recent underperformance compared to other listed non-bank lenders, which the broker says will face ongoing challenging conditions in 2024.

Non-banks had a tough time with rising funding costs and being squeezed out of the mortgage market by the big banks in 2023.

As they saw their clients lured by the banks’ cash backs and low rates, non-bank lenders adapted and instead focused on auto loans, SME loans and personal credit.

Both the industry headwinds and the companies’ response are expected to continue, as reflected in their share prices.

Non-bank lenders such Peper, Australian Finance Group, Liberty, and Resimac, fell a combined 5.6 per cent in the September quarter, as the result season in August revealed the extent of the headwinds the sector is facing.

Pepper Money CEO Mario Rehayem.

AFG and Liberty shares have rebounded in over the two and a half months since then, in line with the broader market. But Pepper stock is set for a second consecutive quarter of losses, down 8 per cent so far this quarter, following the 8.2 per cent fall in the September quarter.

AFG and Liberty are up 9.6 per cent and 15 per cent respectively so far in the December quarter.

Citi says the “divergent” share price returns and the underperformance of Pepper, driven by investor’s discontent with the company’s price-led asset finance strategy, is now “hard to justify”.

“AFG has outperformed over the year, but arguably its key distribution asset is under the largest competitive threat, with which it is responding with material reinvestment to preserve its position,” Citi analysts told clients in a note.

“Both LFG and Pepper have aggressively grown ex-mortgage volumes, but with much less revenue growth as net interest margins have compressed.”

“Arguably, Pepper underperformance has been more of an issue of market expectations. However, given the divergent share price performance, it is difficult to reconcile the two against each other.”

At the industry level, market sentiment has turned in recent months, while industry data is showing non-bank credit growth is starting to accelerate as banks face higher deposit costs. But Citi cautions this doesn’t necessarily mean a recovery in non-bank lender mortgage growth.

“While the system increase in non-bank financial institution credit is encouraging, we note that it captures unlisted NBFIs (i.e. private credit) and we do not know what the split is of the credit growth,” the brokers said.

“We think it is still early for a broad recovery in NBFI mortgages. Competition is easing, but ANZ and Macquarie Group’s ongoing price competition has prevented a more rapid rebound in mortgage profitability.

“The absolute low level of mortgage pricing is likely to remain an ongoing issue for (non-bank lenders’) origination, and mitigation of churn.”

The broker remains cautious and “neutral” on the industry, given price multiples are well off lows, but upgraded Pepper Money to buy, highlighting it prefers it over Resimac, Liberty and AFG.

“Given the persistent challenges in mortgage profitability – the majority of NBFI asset bases – we think a near-term turnaround is unlikely,” they said.